Piercing the Corporate Veil in a Limited Liability Company

Corporations, limited liability companies and limited partnerships are all entities created by statute to limit the liability of owners to the amount of their investments. Although corporations have received bad press recently because of politicians and certain Supreme Court justices taking the idea that corporations are legal people too far for some, they are a vital part of the economic framework of our society.

However, one area in which these entities are clearly not people is if they are set up as shams to hide from liability.  A concept developed called “piercing the corporate veil,” by which a creditor can go after individual owners if certain standards are met.  For corporations, some states, like New York, have statutory grounds for holding certain large shareholders liable for unpaid wages, and there are circumstances in which the Federal government can look through the entity for back payroll taxes, but most of the concern has involved entities that are undercapitalized.  Until recently, though, it has not been entirely clear how one could “pierce the LLC veil.”  Single-member LLCs should take notice.

In the Advanced Custom Builders bankruptcy case from Iowa, plaintiffs had entered into a contract with defendant, a single member LLC, for construction of a home.  Defendant was operated as many single member LLCs are: no meetings, no minutes, no board or other governing body, no one other than the sole member being authorized to act on behalf of the company and no separate office other than one in the owner’s basement.  As is not uncommon (it shows up often in forensic accounting in divorce cases), Defendant commingled funds, paying owner’s personal expenses from the entity.  Defendant accepted some payments, began construction, ran out of funds and defaulted.  Plaintiff then finished up the job on their own and tried to address all the mechanics liens filed by unpaid subcontractors.  Owner filed for Chapter 7 bankruptcy and Plaintiff sought to pierce the corporate veil and have their claims exempted from the bankruptcy discharge for fraud.

The court’s analysis under Iowa law found that the LLC was indeed a sham, largely due to undercapitalization (always easy to determine in retrospect), the lack of formality typical of single person LLCs and the failure to keep personal and business finances separate.  The court spent a great deal of time on the dischargeability of the debt – the LLC was not eligible by statute, and a separate discussion around intention to deceive versus negligent operation of the business came out poorly for the business owner.

The moral of the story is that single member LLCs need to be careful.  They should have separate bank accounts and separate accounting from their owners.  They should be sure to pay any payroll taxes. As with corporations, they need to be adequately capitalized, and they should keep a minute book documenting major decisions.  Sole owners should even consider whether they could benefit from an even more formal structure like a board of directors, even if the owner and his or her spouse are the main participants.